More on Markets and Wealth Effects February 23, 2013 David R. Kotok, Chairman and Chief Investment Officer

We are scheduled for a half hour with Pimm Fox on Bloomberg TV, Monday, February 25, at 5 PM. We plan to discuss our recent commentary on markets and wealth effects. See www.cumber.com for a copy. We are also scheduled for a half hour on Bloomberg radio on Tuesday morning, February 26, at 8 AM with Tom Keene and Mike McKee. I suspect the subject of wealth effects and markets will be on the agenda. We look forward to these discussions on Monday night and Tuesday morning.

Many thanks to readers for the comments on the “wealth effect” piece. Thanks also for the links to other research on this subject. Let’s try to hit a few key points raised in emails.

Liz Webbink, a skilled economist and long-time friend, noted a technical error. I believe, on rereading my text, that she is correct. She suggested a slight change. Many readers do not know that a reduction in debt is an increase in savings. How that debt is reduced is not part of the calculation. So if you pay down your mortgage, your household savings rate rises. And if you sell with a short sale and the mortgage is reduced because a bank takes a loss, your household savings rate also rises.

I wrote, “For the extended, ’93-’12 period, including the financial crisis, the elasticity level reached 0.99. That is, under present circumstances nearly 100 percent of income in the US is spent on personal consumption, when it is adjusted into real terms.”

Liz suggested “For the extended, ’93-’12 period, including the financial crisis, the elasticity level reached 0.99. That is, for each dollar of additional income, 99 cents was spent on personal consumption. Consumers were able to save 5 cents per incremental dollar of income because of the reduction in debt through foreclosures.” Liz also suggested I give readers a link for those who want to delve into this detail. Thank you, Liz.

Some readers asked how high the stock market would have to go to offset the payroll tax hike. That is difficult to estimate, but we will try. Think of it like this. The payroll tax hike is about $125 billion in a permanent shift. If the Credit Suisse elasticity estimates are correct, we would need to multiply that number by about 100 in order to derive the wealth effect needed from stock prices that would offset the reduction of income. That means stocks would need to rise about $12.5 trillion in market value, implying a 60% permanent upward market move.

Of course, that silly calculation assumes there is no change in the housing wealth effect. But we know there would be one, and we have the Credit Suisse estimates that housing has about 3 times the elasticity of stocks. Let’s simplify. A $4 trillion increase in the value of the housing stock would generate about the same consumer spending as a $12 trillion increase in stock prices. Either one would be about enough to offset the $125 billion negative effect of the payroll tax hike.

If we think of the housing stock as worth about the same as the stock market in this post-crisis recovery period, we can estimate a combined housing and stock market outcome. Let’s assume that housing and stocks each start from a present base of around $18 trillion. A crudely estimated 12-15% increase in the national housing stock value and a crudely estimated 25-30% increase in the stock market price level would combine to give us enough positive wealth effect to offset the 2% payroll tax hike.

Now, I hope you can see why the 2% hike delivered to us by President Obama, the Democrats in the Senate and the Republicans in the House was about as dumb a thing as one can conceive.

Dear clients, consultants, professional colleagues, and all readers. At our firm we do not manage policy. We manage portfolios. We do not like this policy of taxing working Americans while engaging in class warfare against wealthy Americans. If we were the czar, we would not do it. But our job is to look at markets and what they will do and why.

The present tax policy combined with very slow growth and cheap money will widen the divide between the rich and poor. If you work and live in America and earn $113,700 or less, you have been kicked in the gut by your president, your senator and your congressman; it makes no difference which political party she or he belongs to. They have all hurt you.

If you have accumulated some wealth, you now face a prolonged period of rising asset prices. Stocks, real estate, precious items, art, collectibles and anything else that benefits from a widening class divide is a target for appreciation. You also face a long period of very low income on your savings. That means you must change the way you invest.

In the very long run this is a terrible policy for America. In the next few years it means a very bullish investment climate.

David R. Kotok, Chairman and Chief Investment Officer

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